How to Develop a Private Equity or Real Estate Fund Model as a Finance Tool

Welcome to our technical paper
This quarter we discuss how a private fund's finance team can develop and use a fund financial model to manage the operations of the fund and deal with sophisticated operational questions.



The article is spilt into two parts as it is somewhat longer than our typical quarterly articles. The first part (permanent link here) is the main overview, while the second part (available from Andrew Read by email if of interest) has more implementation details. I hope you find them useful.


How to Develop a Private Equity or Real Estate Fund Model as a Finance Tool
Private equity and real estate fund models are commonly built during the fund raising period, either to estimate the anticipated returns of a fund based on assumptions about the expected deal flow, or to "replay" the net performance of an historical deal-by-deal track record as if the deals had been done within a fund structure. A fund model can also be a very helpful tool for the finance function in managing the operations of the fund during its life. However in this case, the model needs to be constructed somewhat differently as it will be answering different questions.



Key objectives
Whilst the finance team will also be interested in estimating the expected overall performance of the fund and the likely returns to the LP's and the GP, there are some more immediate questions to be addressed. For example:

•In preparing budgets for the fund manager (e.g. the Cayman manager or the Hong Kong advisory company), what will the management fees be in the coming periods?
•At future closings, what is the likely level of capital equalisations for current and new investors? How much premium are new investors required to pay?
•When making investments, how much additional capital should be drawn down alongside the deal amount to provide for future monitoring and transaction costs?
•What level of working capital reserve, if any, should the fund hold in cash on its balance sheet?
•How can capital calls be planned so that sufficient undrawn commitments will be available after the commitment period to enable management fees and fund expenses to be collected from LP's?
Strategy for building the model

Attempting to build a highly complex, fully automated fund model that can generate all outputs for any scenario at the touch of a button is not usually the best approach. Even surmounting the challenges of building such a model, the time and difficulty of debugging and maintaining all the inherent complexities are probably not a good use of effort for the finance team. A more effective strategy is to break down the challenge into separate pieces that can be maintained on a semi-standalone basis and linked together with some manual support as required. A typical set of separable components might be:

•A carried interest waterfall module that accepts as input an amount of distributable cash (and the total amounts of prior distributions) and operates the waterfall to find out the share to the LP and the GP. A simple preferred return model is also needed as a supporting module.
•A fund cash module that analyses the current balance of cash in the fund according to the use of funds for which it was drawn and projects forward according to budget.
•Individual deal working capital module that track the transaction costs, monitoring costs, and structuring costs against budget deal by deal (this model may not be needed if all deal costs are captured in a single SPV for which accounts are prepared).
•A commitments module that tracks the contributions and distributions, and the balances of drawn, undrawn, and recallable capital for each LP's. This model should also include invested capital and is the main working for estimating future management fees.
•An investment IRR module that summarises the deal by deal cashflows and the end of period investment valuations for gross IRR and multiples estimates.


Populating the model
The Limited Partnership Agreement will be the key source for all of the rules that the model will need to implement. Since often the "devil is in the detail", it is probably best to use the LPA directly as the "manual" for building the model rather than to try and create written summaries that may oversimplify or introduce inaccuracies. Experience in interpreting the LPA is therefore critical. As far as standing data is concerned, instead of trying to maintain a complete history of fund transactions within the model it is probably more efficient to use up-to-date sources such as the drawdown and distribution notices / management accounts prepared by Langham Hall as the latest inputs in many areas. These will summarise, in an organised manner, much of the needed information and are prepared directly from reconciled administration records.



Deriving insights with the model
The carried interest waterfall module will be helpful in anticipating expected distributions and in confirming the required carried interest accruals in the Fund financial statements under US GAAP or IFRS. Whilst it might be unusual to discuss potential distributions with LP's ahead of time, it can be helpful for investor relations to have in mind likely scenarios for upcoming quarter by quarter calls and distributions. Additionally, where a deal-by-deal waterfall operates, it is not uncommon for a GP to review the carried interest model and elect to defer their carried interest on early or small disposals.



The fund cash module is primarily used to ensure that the actual use of capital contributions by the Fund matches the stated purposes for which they were drawn. For example if the final investment amount of a particular deal was more or less than the amount called, then depending on the level of anticipated future transaction expenses there may need to be a further call or return of capital. Similarly for organisational expenses, in which case the fund cap must also be taken into account.



The deal working capital module enables tracking of the balance sheet of each deal, especially where ongoing monitoring costs (and ongoing capital expenditure in the case of real estate funds) need to be matched against available funds, again in case further capital calls are necessary.



The commitments module essentially models the lifecycle of the fund. Alternative scenarios for future calls and distributions should be worked out with the transaction team. One of the most critical sensitivities in this module is the assumed timing of deal divestments. This will drive important insights as to how much capital the fund will have available for recycling before the end of the commitment period, and how much of a buffer of undrawn commitments needs to be kept at the end of the commitment period for management fees and fund expenses after that (since in many case distributions up can be added back to undrawn commitments to the level of drawn fees and expenses).



The investment IRR module can be used both to validate reports such as the EVCA return on investment note, and also generate commentary for the managers section of the quarterly report, as well as looking at potential exits and their resultant multiples and IRR's.



A rigorous approach to answering these and other questions proceeds in two stages. Firstly, the relative sensitivity of the key inputs is established by varying them in turn whilst holding the other factors constant. Then some integrated scenarios are created that combine assumptions for the key inputs according to various business cases. The timing of decision making is also important. For example at the very start of the fund life it may be assumptions are necessarily very broad and the resulting model insights correspondingly so, yet by the end of the commitment period flexibility around investment drawdowns (and therefore the window of opportunity to take certain decisions) will be coming to a close. Therefore a review of the fund model at least each quarter is important.



Conclusions
Building a fund model to support the finance function can be a very helpful management tool. A modular approach with separate units for carried interest, fund cash, deal working capital, commitments and deal IRR's is likely to prove most successful. Optimum value can be had from the model when it is reviewed an updated on at least a quarterly basis over the lifecycle of the fund. Various insights can be obtained by identifying key sensitivities and creating integrated scenarios around them. The second part of this article focuses on more detailed implementation issues and is available by email if of interest or feel free to call Rob Short.

Langham Hall Hong Kong appointed as administrator by NewQuest Capital Partners

NewQuest is a private equity manager lead by the former Bank of America Merrill Lynch Asia private equity team.

We are delighted to announce that Langham Hall Hong Kong has been appointed by NewQuest Capital Partners, a newly-established private equity manager lead by the former Bank of America Merrill Lynch Asia private equity team, to administer the NewQuest Asia Fund I, L.P.. The fund is backed by a syndicate of limited partners comprising Paul Capital, HarbourVest Partners, LGT Capital Partners and Axiom Asia and has acquired substantially all of Bank of America Merrill Lynch’s non-real estate private equity portfolio in Asia.

Andrew Read, Partner and Head of Asia at Langham Hall said: “We are excited to be working with such a well regarded investment manager and team. We look forward to developing a long standing relationship with NewQuest."

Darren Massara, NewQuest’s Managing Partner, said: “Having considered a number of administrators, we selected Langham Hall who have a particularly strong focus on private equity funds. Their detailed approach, deep sector knowledge and reputation for excellence and class leading systems were key considerations in our selection.”

Langham Hall has been appointed as the onshore administrator to Chamonix Private Equity

Langham Hall has been appointed as the onshore administrator to Chamonix Private Equity

UK private equity fund administrator Langham Hall has been appointed as the onshore administrator to Chamonix Private Equity, the London based private equity investor. Langham Hall will be providing accountancy and administration services for the fund that has acquired a portfolio of five non-core businesses from plastic packaging manufacturer Linpac Group.

“We are excited to be working with such a well regarded and experienced team. We look forward to developing a long standing relationship Andrew Hartley and Jane Crawford’s team,” said Langham Hall’s Head of Private Equity Mark Coppin.

Andrew Hartley said, “Having considered a number of administrators, we selected Langham Hall who have a particularly strong focus on private equity funds. Their detailed approach and experience, sector knowledge, reputation for excellence and class leading systems were key considerations in selecting Langham Hall.”

Langham Hall has been appointed as the offshore Guernsey Administrator to Cubera VI

Private equity fund administrator Langham Hall has been appointed as the Guernsey administrator to Cubera VI.

Cubera VI is a secondary fund focusing on purchasing LP shares in Nordic buy-out funds, the advisor to the fund is Cubera Private Equity AS a Nordic investment firm specialising in secondary transactions in the Nordic private equity market. Since inception in 2006, Cubera Private Equity has established six private equity structures.

Cubera Private Equity represents the most comprehensive team set up for secondary transactions in Nordic private equity. The professionals have more than 60 years of combined private equity experience and been responsible for more than 40 secondary transactions, 57 primary fund investments, 100 direct investments and 50 exits

Axel Hovo Daasvand said, “Having completed first close in our first Guernsey based fund, I applaud the way Langham Hall has assisted us throughout the process of documentation and registration of the fund. I look forward to working with them throughout the life of our fund.”

Mark Coppin Head of Private Equity at Langham Hall said " We are delighted to have been appointed Administrator to Cubera Private Equity's new fund and to increase our presence in the Nordic region, which we believe is an important geography for both private equity and real estate. We look forward to working closely with Axel and all of the team at Cubera".

7th April 2011

Langham Hall wins “European Property Fund Administrator of the Year” award

Langham Hall is delighted to announce that it has won the “European Property Fund Administrator of the Year” award at International Custodian and Fund Administrators ceremony held in London at the Northumberland Hotel, on 23rd November 2010. Rob Short, principal – collected the award on behalf of the Langham Hall team. Rob Short commented "Given that it was an independent judging panel and the quality and size of the other nominees we are clearly delighted to have won this award. We continue to believe that real estate funds need a highly specialised and more flexible platform to be able to cope with the nuances of this asset class."

Langham Hall has been shortlisted for the BVCA "Specialist Professional Services Firm of the Year" for the second year running

Langham Hall has been shortlisted for the British Venture Capital Association (BVCA) "Specialist Professional Services Firm of the Year" for the second year running. This recognises not only our achievement in Private Equity but also highlights how we consistently deliver above the norm and provide our clients with bespoke solutions. This nomination builds on our success, last year, when we were privileged to be selected winner of this prestigious award and believe that this industry recognition is statement of how Langham Hall is a market leading specialist in the funds arena. Co-founder Rob Short commented "We are delighted that once again our efforts are being recognised in this way by the industry. To be short listed for a second time, after winning the award last year, in such a competitive field highlights our continued focus on quality rather than quantity."

AIFM DIRECTIVE UPDATE

The outgoing Swedish Presidency of the European Council has circulated a progress report on negotiations relating to the Alternative Investment Fund Managers Directive and has produced its final "compromise text", although still subject to debate, are encouraging and improve on the conditions for valuation and delegation, on which agreement will not be reached before the Spanish assume the Presidency in January.

The progress report identifies the key outstanding issues and the compromise proposal makes some concessions to the issues unresolved.

The issues of capital requirements, depositary, third countries and portfolio company disclosure remain a concern for the private equity industry and EVCA is working on its own draft amendments, supported by its subcommittee, the Public Affairs Executive (PAE).

Please visit www.bvca.co.uk/in-europe for further information about the BVCA’s campaign on the EU AIFM Directive.